The Monster that's eating Coke

By Jon Markman

Man, you must be tired.

With the start of school just around the corner, fresh X Games recordings on the DVR and a lot of last-minute summering to get done, there's little time for shut-eye. There's been inflation for just about everything these days but 40 winks. If you can get 10, it's sort of a miracle.

This perpetual state of half-dead wakefulness explains one of the most amazing consumer phenomena of modern times: the rise of the carbonated energy drink.

Back in the day, a steaming hot mug of coffee got the blood flowing. If you wanted to hype it up, you heaped in half a pound of sugar. Lately, though, the foam is coming off the latte. Second-quarter earnings results at Starbucks (SBUX, news, msgs) announced last week were lukewarm, sending the company's shares down 11% in a day to a 10-month low.

The coolest thing now for the sleep-deprived is an ice-cold can of nasty-tasting stuff with Goth graphics, the word "energy" somewhere on the label and a loopy marketing scheme that somehow combines skateboarding, fast times, sex and herbalism. Industry surveys show kids think Coke and Pepsi are for grandma and dorks. They want a fizz with attitude and a twist: Tony Hawk, not Bob Dole. Energy-drink sales are up 70% from last year, with a bullet.

O-Pium and Nitro2Go

To get a taste of the fact that American innovation is alive and freaky, you need to check out a retailer where this stuff is sold. You've never seen so many weird new products. Their names alone will scare you awake. Get ready for some Sentinel Vigilant Energy or Recon Coffee Energy Cola in a camouflage can (from Jump Beverages), Monster Energy ("Unleash the beast"), Black O-Pium Energy Drink (featuring reishi mushroom extract, Chinese "herb of spiritual potency"), Sum Poosie Energy Drink (featuring cute "bottle models"), XO Energy Drink ("Xtreme Energy for Xtreme People") or Nitro2Go ("When slowing down just isn't an option") and Sex Kola ("enhanced with the herbal aphrodisiac yohimbe").

Phew, it wore me out just doing this research. As you might imagine, most of these companies will last about as long as your average sugar high. But there are a few public companies with earnings that are surging on the strength of energy drinks. And so it is possible for investors to make a buck off this urge for a personal power surge.

The good news, if you're just tripping into this idea, is that the stocks of the top energy-drink manufacturers are all getting killed this week despite reporting strong second-quarter results. The reason is as ancient as ginseng: Expectations have been so high that anything less than XXXL-sized numbers are considered disappointing.

The biggest name in the sector is Red Bull, a pioneering Austrian company that has no public shares. So we'll skip them and go straight to Hansen Natural (HANS, news, msgs), the owner of the powerful Monster brand, the leading 16-ounce energy drink in the United States, and the Lost brand, which is the eighth-best seller in the country.

Hansen has quite possibly been the greatest stock in the market over the past three years, as I reported a few months ago, rising 9,350% from January 2003 through early July of this year. It is a very well-run company, at least by the numbers, with a return on capital of 65%, which is triple the industry average.

As you might expect, expectations got completely out of whack after success like that, and investors who came on board in the past year were burned this week when Hansen Natural announced second-quarter earnings of 28 cents per share, up 77% over the year prior, on an 83% advance in net revenues. Normally, those kinds of results will send a stock flying, but these were right in line with analysts' expectations -- a big no-no for a company that has beaten expectations by up to 40% in the past four quarters. As a result, Hansen stock was hammered, sinking 25% on Monday.

The price of addiction

So is it a buy now? Maybe so, and the reason is that there just are not a lot of premium companies that are right in the thick of such a high-energy trend. And they had some pretty good reasons for the disappointing results: Management pointed to rising aluminum prices that affected their can costs, and an uptick in marketing to get the word out.

I can certainly understand the latter, and how it ultimately has a positive impact. Every time I leave Safeco Field after watching a Seattle Mariners game with my family, we see a black truck where handsome men and women are handing out free Monster and Diet Monster cans. My 13-year-old son and 11-year-old daughter, both athletes who feel like they need a kick before playing in early morning baseball or soccer games, now think Monster. And since they're advancing toward the target age for Hansen advertising, this expensive but useful marketing trick must sadly be laying the foundation for their future addictions.

The question now is how investors should value Hansen. Citigroup analyst Gregory Badishkanian has done some good work on this subject. He was bullish up until last week, when he put out a big and unpopular Sell rating on the stock, saving his clients a lot of money. After the 35% plunge in the past few days, he's now a lot more positive about the company.

Target: 85% gains

Badishkanian's argument goes this way: Hansen's stock price has traded at between a 75% discount and a 130% premium to mature beverage companies such as Coca-Cola (KO, news, msgs) and Anheuser-Busch (BUD, news, msgs) over the past two years, with a median 35% premium. He figures that Hansen should trade at a 125% premium because it has much stronger near- and long-term earnings and revenue growth prospects. Growth of 20%-plus should be no problem for the company, vs. a maximum of 9% for the Coca-Colas and PepsiCos (PEP, news, msgs).

To get a target price on the stock, Badishkanian applies a 125% premium to the mature beverage stocks' average price-to-earnings multiple of 18.4 to get a 41 multiple. He then applies that against his 2007 estimate of $1.30 per share to arrive at a price of $53, which is 85% higher than the current price. Even if that's half wrong, you still have the opportunity for a lot of upside.

Now before you rush out and chug the shares, be warned that the stock can still fall another 50%, to the $15 area, before becoming truly cheap. At around that level, the best reason to consider Hansen is those energy drinks. Citigroup estimates that the category will grow its sales volume at least in the mid-teens through 2008, vs. around 3% for colas. And there's a strong catalyst ahead, as Anheuser Busch will start distributing Hansen's energy-drink products through its powerful worldwide network this summer.

Now if Hansen is too mainstream for you, then consider some of the other energy and soda micro-pops that have emerged as public companies in the past few years. They were all flattened this week following the Hansen disappointment, and are starting to offer much more attractive entry points for new investors.

A top name here in Seattle is Jones Soda (JSDA, news, msgs), a micro-cap company that has grown through the brilliant marketing of oddball soft drink names and a long-running, viral campaign to make its fans' love for the product part of its appeal. Consumers' photos decorate Jones bottles and kick up the wattage of its Web site. Its energy drink is called Whoopass, and results are starting to look impressive, with a return on capital of 20% and improving profitability. Our StockScouter system has given the stock its highest rating, 10, for more than a year as it has doubled in price. If you can buy shares around $7.55, Jones could amp your portfolio; the shares are now around $8.40.

Most of the other top companies in energy drinks are also small. They include Leading Brands (LBIX, news, msgs), out of western Canada, and National Beverage (FIZ, news, msgs), out of Florida. A lot of the bubbles have been coming out of their valuations, but they are still probably too expensive, even for strong names in a growing category. For now, stick with Hansen at a steep discount: If it trades down to the $15 to $20 area during a hot and difficult summer, then you can really stock up.

Fine Print

To learn more about National Beverage's Rip It energy drink, click here. To learn more about Monster, read here. ... Read more about Jones energy drinks here. … The Web site BevNet features reviews of energy drinks. Here's the review for Whoopass. As you might expect, someone has put up reviews of a lot of energy drinks. You'll find them here.

By far the coolest thing in energy-drink marketing is the Red Bull Air Race World Series, which is broadcast by ESPN on Saturdays. It's wild! Learn more here. … My own favorite? This column was fueled by Diet Red Bull.

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Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Jon Markman owned shares of Starbucks.